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China and the U.S. appear to be on a collision course over
accounting. That’s a lot more serious than it sounds.
By the end of this year, unless a compromise can be reached,
there is a very real chance that U.S. securities regulators may
end up employing the “nuclear option”: forcibly delisting
every Chinese company currently listed on a U.S. stock exchange —
such as Sinopec, Sina.com, China Life, and China Unicom.

It’s a potential catastrophe-in-the-making that few investors or
politicians have given any serious thought to.

Last year, the US-listed stocks of more than a few Chinese
companies took a beating following accusations by short sellers
and research shops like Muddy Waters that SinoForest and other
companies — many of which had avoided IPO scrutiny by arranging
reverse mergers with already-listed entities — were grossly
exaggerating their real assets and business performance in their
official financial statements. These accusations prompted
the Securities and Exchange Commission (SEC) to launch several
fraud investigations into the Chinese companies in question.

Rather than assisting the SEC in its cross-border probes — as
other countries regularly do — the China Securities Regulatory
Commission (CSRC) has actively blocked the SEC’s
information requests, insisting that audit materials on
Chinese firms fall under China’s ambiguous yet draconian State
Secrets Law. This April, when the SEC issued a subpoena to
the Chinese arm of Deloitte, demanding the audit records of
Longtop Financial (which collapsed last May after Deloitte
resigned as its auditor), Deloitte refused, noting that
the CSRC directly ordered them not to turn over such papers.

There is a further complication: The Sarbanes-Oxley Act also
established the Public Company Accounting
Oversight Board (PCAOB), a five-person body appointed by the
SEC. Public accounting firms that wish to perform audits on
US-listed companies must register with PCAOB, and PCAOB is
required, by law, to conduct inspections of those firms. So
far, Chinese authorities have refused PCAOB permission to inspect
auditors based in China, including the local arms of “Big Four”
global audit firms. Last month, it looked like PCAOB might have worked out a
compromise that would let it observe Chinese
regulators perform their own inspection, but the SEC action
against Deloitte China appears to have derailed that plan. The
stage is set for a deadlock with serious, potentially disastrous
implications, as my fellow CPA and Peking University counterpart
Paul Gillis describes in his
blog:

The PCAOB faces a December deadline to complete inspections of
Chinese accounting firms that are registered with the PCAOB. It
seems highly unlikely that they will meet this deadline, since
Chinese regulators will not let them come to China. While the
PCAOB could extend the deadline, they have already been under
political pressure to act … Without resolution, the only
meaningful option for the SEC, and the PCAOB, is for the PCAOB to
deregister the firms and for the SEC to ban them from practice
before the SEC.

The consequence of those actions would be that U.S. listed
Chinese companies would be without auditors and unable to find
them. Having an auditor is a listing requirement of the
exchanges, so under exchange rules the companies face delisting.
The U.S. listed Chinese companies would be unable to file
financial statements as required. That should lead the SEC to
eventually deregister the companies with the SEC.

Paul notes that shareholders in the delisted Chinese companies
would still own their shares, but would be unable to trade them
on U.S. exchanges. The companies would probably try to list
their stock on other non-U.S. exchanges such as Hong Kong, which
could prove an expensive and cumbersome option. The effect
on US-China relations, and on investor confidence in cross-border
investments in either direction, would be devastating. Yet
the alternative would be to allow Chinese companies to trade
their shares on U.S. exchanges while openly flouting U.S.
securities laws — not just Sarbanes-Oxley, which is somewhat
controversial, but anti-fraud provisions dating back to the
1930s.

In the meantime, Chinese regulators have been moving to exert
even greater secrecy and control over companies’ financial
information. Local bureaus of the State Administration for
Industry and Commerce (SAIC) have started restricting public
access to domestic corporate filings, after short sellers and
analysts used information gleaned from those filings to call
company financial statements into question. Of more
immediate concern, the Ministry of Finance is following through
on plans to force the “Big Four” global audit firms to surrender
majority control of their Chinese operations over to local CPAs,
and dramatically reduce the number of foreign-certified CPAs they
employ. As Paul Gillis notes on his blog:

One of the unintended outcomes of the restructuring of the Big
Four in China will be that the firms will likely be required to
re-register with the PCAOB. That could pose a problem,
since the PCAOB has said they will accept no new audit firm registrations from
China until the issue of inspections is resolved.

I was pondering the irresistible-force-meets-immovable-object
dilemma here last night when I happened across a seemingly
unrelated passage in Jim Fallows’ new book China
Airborne, which offered a glimmer of hope.

In 1997, Jim relates, three Chinese airlines — Air China, China
Eastern, and China Southern — had just been awarded, or applied
for, very prestigious and strategically important routes to the
United States, and had purchased brand-new state-of-the-art
Boeing planes to fly those routes, with many further orders
expected. However, the safety record of Chinese airlines in
the 1990s was atrocious. In order to actually fly those
routes, the airlines required approval from the U.S. Department
of Transportation (DOT), the parent body of the FAA. The
DOT, at the FAA’s urging, demanded “confirmation that China’s
regulatory standards, as applied by the CAAC, conformed to the
worldwide guidelines laid out by international agreements.”
Until then, it was no fly.

The Chinese were furious, believing the Americans had
double-crossed them by selling the planes and then reneging on
the routes. The whole thing could have concluded in
respective chest-beating and a very ugly, damaging
stand-off. Instead, Boeing took the initiative (since its
future sales were on the line) through a series of seminars,
tours, and training sessions to reconcile the two points of
view. Key to its success was the way it handled Chinese
sensitivities:

One [way] was to present all their recommendations in terms of
meeting international standards for air safety and airline
procedures, rather than seeming to say, This is how we do it in
the U.S. of A. Presenting the challenge this way made it
far more palatable to the Chinese side. Learning to comply
with international standards was one more sign of modernization
in China; doing things the “American way” could seem like a sign
of continued subservience. The examples were, of course,
from American practices at the FAA or the operational details of
Boeing and United Airlines, but the leitmotif was that Americans
had learned how to make their practices meet international
standards, and they could help the Chinese do the same thing.

Bridging the gap in securities regulation will surely be more
difficult than fine-tuning some phrases — especially since
Chinese companies that truly are fraudulent have a lot to
hide. But Chinese aviation officials had a lot to hide too,
back then. Many of them, once they realized how far they
fell short of “international standards,” doubted whether they
could ever make the grade, and feared losing face and making
others lose face if they tried. But working with their
American partners, they succeeded: China’s airline industry
today has an admirable safety record, which has laid the
foundation for ambitious plans for China to claim a leading role
in the global aviation industry. Caixin reports that at least
some officials at CSRC are sympathetic to what the SEC is trying
to achieve, and they certainly don’t want to seem too far out of
step with their international (and much more cooperative) peers.

If China wants Shanghai to become a “global financial center,” or
the Renminbi to develop into an “international currency,” it has
to do the same thing in securities regulation that did in airline
safety regulation. It has to win the confidence of global
investors just as it successfully won the confidence of global
travelers. China closing the windows and battening the
hatches to avoid embarrassment is not a solution; but neither is
Americans telling the Chinese “it’s our way or the
highway.” The U.S. has to make a forceful, compelling
argument that adopting international norms of openness and
cooperation will help China achieve its ambitions — but that
until then, it’s “no fly” for unsafe stocks on U.S. markets.